Tough Call -- Part II

Q:Any other opportunities? A: Steel stocks are still outrageously cheap, believe it or not. Multiples are still around six-seven-eight times earnings and demand is strong. Nissan ran out of steel and couldn't make cars for a week a couple of weeks ago. And there will be more acquisitions in the group.

Q:Talk about energy. A: Analysts are now working $40 oil into their estimates for next year. In the smaller exploration-and-development companies, there is good money still to be made. The whole energy area only makes up about 8% of the S&P and accounts for maybe 12%-13% of the earnings in 2005. I remember when energy made up 28% of the S&P. Energy could go to 14%-15% of the S&P. We're positive on energy and we're still positive on sectors where there are going to be continued shortages as the global economy continues to grow, such as the industrial metal area. Investment in that area lagged for 15 years and all kinds of mines and facilities were shut down and yet demand continued to grow at 2&frac12;%. Now the growth rate is 3&frac12;% and 4%. Inventories at the London Metal Exchange and elsewhere are just running right down through the floor.

Q:You also think utilities are attractive, don't you? A: We have 13% in utilities. We have those utilities that are fixed-income proxies, conventional high-yield utilities, which we view as a source of funds now. But then there are the unregulated power producers that are also classified as utilities. Companies such as
Reliant Energy
and
AES
that got into trouble by expanding in the late 'Nineties. Boy, have they been cleaning up their balance sheets. They've been refinancing at lower levels and if we assume this country is still going to grow in terms of electrical usage, these are very, very cheap and very attractive. Even the dog of the whole group,
Calpine,
has just done a refinancing with
General Electric. The unregulated electric power producers could be one of the most dramatic parts of our portfolio. They've been neglected partly because we had a cool summer and electric demand wasn't as great as people expected. But they also were able to clean up their balance sheets in many cases. And they have started to increase plants. It could be a long time before nuclear power is coming back in this country and we are going to rely more on the [conventional] electric power producers.

Q:How does it look for small-cap leadership?A: The momentum in small-caps picked up again in November and I'm not so sure that we are at the end of the road. It has been six years of small-cap leadership but there is nothing to say it can't run seven. They are at a P/E premium now to large-caps, which is quite unusual. But momentum is still there and they could have another year. But the small-cap-growth category of mutual funds, which typically would be one of the more exciting ones, is about the worse performing subset in terms of money flows that we see in the mutual-fund complex suggesting the public isn't interested at all. The hot area is foreign investment; 10 months into the year and the flows into foreign-focused mutual funds have exceeded any 12-month period we've seen in the past. That's scary.

Q:Aren't you still pretty high on emerging markets? A: We just started to trim back emerging markets, taking it down to 8%. We've been up as high as 14% in emerging markets and as low as 5% since 1996. We're a little concerned it is becoming a little too popular. China still looks attractive, but South American stocks have really been on a tear. Eastern Europe is still good and Russia is still good, but there are pockets in Asia and certainly in South America where enthusiasm has gone a little too far.

Q:What's your view on gold? A: If you look at a price chart of gold in euros it has been in a trading range that it has not broken out of for the last 3&frac12; years. That shows the decline in the dollar has been the biggest factor in the rise of gold in the last nine months. Gold to us is not terribly attractive. Sometimes gold is a hedge against international problems. Sometimes it is a hedge against inflation and sometimes it isn't. If people want to own gold they should own some physical gold and use it for catastrophe insurance in case the deficits go off the charts and the dollar goes through the bottom. It is like fire insurance; you have a bit of it but hope it never pays off. Gold doesn't excite me but silver does. Silver is an industrial metal; about 60% of its applications are industrial. We own
Hecla Mining,
which is a silver stock, but we just gave up on and got rid of
Apex Silver Mines.

Q:Have you added anything new to your portfolio?A: We added some small industry groups such as agricultural products, where
Archer Daniels Midland
would be the biggest name. The group was very, very strong on all our quantitative disciplines. We also bought some
Bunge.
It is also a lower beta or more defensive type of group historically. We also bought some photography and photo-equipment stocks, basically
Eastman Kodak.
In the past, we disregarded these small groups because there just wasn't enough market value there. But we've decided to take as much as 10% of our portfolio and devote it to these small groups -- mainly those with less than $25 billion of total market value -- and have about 5% there now. That's a relatively new thing for us.

Q:Health care was a big play of yours last year. Is it still? A: We are still overweighted in health care at about 13% of our equity portfolio assets, mostly in the area of health-care cost containment. We are sniffing and sniffing at the drug companies. Generic-drug stocks were a big holding of ours but we sold them back in February, lucky for us. But I'm really enamored of Big Pharma, yet so far our quantitative disciplines have kept us out of them.

Q:For what reasons? A: It is a combination of shrinking margins and continued poor relative strength or continued poor strength. The earnings surprises have been surprisingly bad. They look like bargains to us but I've felt they've been buys for the last six months and thank goodness the numbers have kept us out of them.

Q:So what makes you enamored of them?A: The long-term demographics are compelling. We are going to be spending more on health care. Pharmacological treatment of illness is far cheaper than hospitalization, even if drug costs are very high. The margins are huge; if they come down they are still damn good. The return on equity is good. The P/E multiples are now very low historically in most instances or back to 1991-1992 levels. They make my mouth water.

Q:What about the technical supports for the market? A: The technical underpinnings of the market still look extremely attractive. Breadth is terrific. It is not the type of thing you would normally see at a market top, but the advance-decline lines for small-caps and for the S&P 500 and mid-cap stocks are all making new highs. In fact, they are running a bit ahead of the price indices and that would be very, very unusual action for a market top. There is a heck of a lot of potential liquidity here. You know if the public got a little more enthusiastic, there is still lots of money in those money market funds with no return that could find its way into the stock market. And corporations have caches of cash. I wouldn't be at all surprised to see -- since they don't seem too anxious to increase dividends and shareholders actually haven't been very demanding about it -- a lot of M&A activity coming up in 2005, which would be a positive stimulant for the market. We are already seeing some of that emerge right now. With all the money in hedge funds you are going to see a lot of people trying to play those deals. That's a positive, but there is enough that is disturbing on the horizon that I'm not willing to say full speed ahead just because the technicals look good and the liquidity potential looks great. This bull market is two years long and has run about the course of a normal cyclical bull market in terms of amplitude and duration.

Q:If that's the case then what's in store?A: Historically you've had sideways movement without much more upside progress and ultimately you've seen a decline. A cyclical bull market is generally followed by a cyclical bear market of maybe a 20% to 30% decline and that's enough to be disquieting.

Q:And the dollar decline? A: I am not that worried about the dollar as some people are and, in fact, I just shorted some euros recently -- not for the fund but for myself.

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